Calculating commercial property value is a notoriously tricky thing to get right. Fortunately, there are a few different tricks from the real estate industry that are used to make such calculations more accurate and a little easier to use.
By its very definition, the commercial property value is nothing more than the price paid for the purchase of a given property, agreed upon by the seller and buyer. In economic theory, this value converges precisely at the point where supply and demand collide. In plain words, the value of a certain property is largely determined by the market.
Yet, in the real world, things are not always quite so simple. This is because there are many things that can affect the willingness of the buyer to meet the set price, including but not limited to their motivation to buy that set property, the that takes place, the condition of the property, and a myriad of other factors.
This is why the price agreed upon, and the final price when the sale happens is taken as the final commercial real estate value for a particular property. But, to better calculate this and to have more leverage in negotiating prices, long ago the real estate wizards came up with the tools to help estimate/calculate the property value, such as the Net Operating Income (NOI), and the Capitalization Rate (Cap Rate).
NOI – Net Operating Income
Since we are determining the value of a commercial piece of property, it is a good idea that we take a look at how business was going before, isn’t it? Thus, we take a look at the real black and white picture of the profitability of commercial real estate.
We take all of its income made during a set period and subtract all of the necessary operating expenses. Simply put:
Gross Income – Operating Expenses = NOI
There is another term used here – EBITDA, which literally means Earnings Before Interest, Taxes, Depreciation, and Amortization. All of these aspects are either short or long term figures we need to factor in calculating commercial real estate value.
Cap Rate – Capitalization Rate
People who are looking to purchase a specific commercial property would often want to look at its capitalization rate. This is because it shows, in a single percentage figure, what is the expected rate of return on their investment after purchasing it.
The capitalization rate is calculated again from the net operating income of the commercial property, but this time that figure is divided by the asset value of the property and expressed as a percentage. It is one of the most important figures in real estate management, obviously, and agents often sort entire building areas by their estimated cap rates.
In plain words, the cap rate will show the person who wants to buy the commercial property the rate of return for their invested money, based on NOI and the price. If you don’t know the cap rate for your building, for instance, just look at the cap rate for similar buildings in your area.
So, once we have all of the figures and formulas required, we can do the calculations with no problem. The capitalization rate formula is as follows:
NOI / Current Market Value = Cap Rate
This means that if the NOI for a given commercial property is $120,000 and it was sold for $1,000,000 bucks in the last six months, we get that the cap rate for that property is 12%.
But, let’s say you own a commercial property, and you want to calculate the price for it, perhaps for potentially selling it. As an owner, you should have access to your NOI (gross operating income). However, since there was no sale of the property in the last six months or even years, what you need to look at then is the cap rate for your area.
Then, you would again have two out of 3 variables known, and the calculation is a simple one.
NOI / Cap Rate(divided by 100) = Price
If we take the same example as before, where NOI was $120,000 and the cap rate for your area is 9%, the calculation would go as follows:
$120,000 / 0.09 = $1,333,333 (approximately)
The three main approaches
When it comes to calculating commercial real estate value, there are three main approaches you can take, these are:
Market value approach
The market value approach takes into account the recent sales data of properties sold in the surrounding area. This is done by assessing the final sales figures of comparable properties which then sets a precedent for fair market value.
These are all handy tools for commercial property management companies as well as those looking to both buy and sell such properties.
This approach uses the revenue that the property generates to help estimate fair value. It’s calculated by dividing the net operating income by the capitalization rate, as we have shown above.
Replacement cost approach
Instead of focusing on the property’s ability to generate an income, this approach looks at how much the building would cost if it were torn down and rebuilt again from scratch. This requires calculating the entire cost for the replacement of each part of the property and takes into account the value of the land surrounding the building.